Hotelling's law

Hotelling's law is an observation in economics that in many markets it is rational for producers to make their products as similar as possible. This is also referred to as the principle of minimum differentiation as well as Hotelling's linear city model. The observation was made by Harold Hotelling (1895–1973) in the article "Stability in Competition" in Economic Journal in 1929.

The opposing phenomenon is product differentiation, which is usually considered to be a business advantage if executed properly.

Suppose that there are two competing shops located along the length of a street running north and south, with customers spread equally along the street. Each shop owner wants to locate his shop such that he maximises his own market share by drawing the largest number of customers. In this example, the shop itself is the 'product' considered and both products are equal in quality and price. There is no difference in product to the customers. Therefore, each customer will always choose the nearest shop because there is no difference in product or price.

For a single shop, the optimal location is anywhere along the length of the street. The shop owner is completely indifferent about the location of the shop since it will draw all customers to it, by default. However, from the point of view of a social welfare function that tries to minimize the sum of squares of distances that people need to walk, the optimal point is halfway along the length of the street.

Hotelling's law predicts that a street with two shops will also find both shops right next to each other at the same halfway point. Each shop will serve half the market; one will draw customers from the north, the other all customers from the south.

Another example of the law in action or practice is to think of two food pushcarts at a beach. Assume one starts at the south end of the beach and one starts at the north. Again assuming a rational consumer and equal distribution along the beach, each cart will get 50% of the customers, divided along an invisible line equidistant from the carts. But, each cart owner will be tempted to push his cart slightly towards the other, in order to move the invisible line so that it encompasses more than 50% of the beach. Eventually, the pushcart operators end up next to each other in the center of the beach.

Obviously, it would be more socially beneficial if the shops separated themselves and moved to one quarter of the way along the street from each end — each would still draw half of the customers (the northern or southern half) and the customers would enjoy a shorter travel distance. However, neither shop would be willing to do this independently, as it would then allow the other shop to relocate and capture more than half the market.

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